COST ESTIMATION

Meaning of cost
The scope of the term 'cost' is extremely broad and general. It is, therefore, not easy to define or explain this term without
leaving any doubt concerning its meaning. Cost accountants, Economists and others develop this concept of cost according
to their needs. This concept should therefore be studied in relation to its purpose and use. Some of the definitions of cost are
given hereunder:
 "A cost is the value of economic resources used as a result of producing a product or service" (WM. Harper)
 Cost is "the amount of expenditure (actual or notional) incurred on or attributable to a given thing" (ICMA)
 Cost is "an exchange price, a foregoing, a sacrifice made to secure benefit" (A tentative set of
Broad Accounting Principles for Business Enterprises)

Level of activity
The level of activity is the amount of work done or the number of events that has Occurred.
The type of activity which influences cost varies according to the nature of work done in the organisation or department, and the nature of
the items of cost whose behaviour is being analysed depending on the circumstance. The level of activity may refer to:
 the volume of production in a period,
 the number of items sold,
 the value of items sold,
 the number of invoices issued,
 the number of invoices received,
 the number & units of electricity consumed,
 the number of units registered by a student, etc.

Concept of Cost Behaviour

Cost behaviour is the study ofthe ways in which cost react or do not react to changes in the level of activity of an organisation.
Knowledge of cost behaviour is the basis of all cost-volume-profit (C.V. .P) analyses. When we know the behaviour of costs, then
financial planning is made simpler.

Reasons for studying cost behavior

There are three principal reasons for studying how costs respond to changes in the level of activities:
 For the prediction of cost to facilitate budgetary and corporate planning
 For performance evaluation when a system of flexible budgetary control is in operation
 For the estimation of costs for various decision making processes e.g. pricing decisions, make or buy decision, optimal
product mix, shut-down decisions etc

Determining how cost will change with output and other measurable factors of activities is of vital
importance for decision making planning and control. Knowledge of cost behaviour is necessary across the
whole range of cost account and management activities particularly in areas of cost extra planning and
decision making. The preparation of budgets, the productions of performance reports, and the calculation of
production cost on the provision of relevant costs for pricing and other decision all depends on reliable
estimates of costs and distinguishing between fixed and variable costs at different activities levels.
Unfortunately costs are not easy to predict since they behave differently on different circumstances.

Need for Cost Estimation

Recall there exists a mixed cost or semi-variable cost or semi-fixed cost. These are said to be costs which are partly fixed and partly
variable i.e. a cost which is a composite of a standing basic charge plus a variable change per unit of consumption. If all
costs are to be classified as either a fixed cost or a variable cost, then a mixed cost has to be so separated into its variable and
fixed costs components.
 Illustration

Imagine the telephone bill received from Telkom Even in situations where the telephone is still out of service, you still receive a
bill for the month. You would wonder where the charges came from. Well, it is the standing charge for having a line, which
would carry a fixed charge. And in addition to this, you pay a constant variable charge per usage. The two changes would
have been added together and sent to you as a bulk, which you may have to separate for planning purposes and
budgeting.

Method of Estimating Costs: Include:-

1. Engineering methods
2. Inspections of Accounts Methods
3. High-Low Method
4. Graphical and Scatter Graph Methods
5. Regression (Least Square Methods)

1. Industrial Engineering methods

Engineering methods of analysis cost behaviour are based on the use of engineering analysis of technological
relationship between inputs and outputs. The approach is appropriate when there is a physical relationship
between cost and cost driver. The procedure when undertaking an engineering study to make an analysis
based on direct observations of the underlying physical qualities required for a activity and then to convert
the final results with cost estimate. Engineers who are familiar with the technical requirements estimate the
quantities of materials, labour and machine hours required for various operations. Prices and rates are then
applied tot eh physical measures to obtain the cost estimates. The engineering method is used for estimating
costs of repetitive processes where input/output relationships are clearly defined.

2. Inspection of the Accounts Method

This method requires that the department managers and the accountant to inspect each item of expenditure
within the accounts for a particular period and then classify each item of expense as wholly fixed, wholly
variable or semi-variable costs. A single average unit cost figure is selected for the items that are categorized
as variables whereas a simple total cost for the period is used for the items that are categorized as fixed cost.
For semi-variable items, the departmental managers and the accountants agree a cost function that appears to
best describe the cost behaviour.

Cost function == C= a + bx, Where: a= fixed cost, b= variable cost/unit, and c= quantity
There is a need to obtain an estimate of a & b so that once a sales forecast (demand), x is obtained, then T.C.
can be predicted.

Illustration
The following cost information has been obtained from latest monthly accounts for an output level of 10,000
units for a cost centre
Direct materials 100,000/=
Direct labour 140,000/=
Indirect labour 30,000/=
Depreciation 150,000/=
Repair and maintenance 10,000/=
295,000
Required
Determine the cost of function using the accounts analysis method
Solution
Variable cost Fixed cost
Direct material 100,000
Direct labour 140,000
Indirect labour 30,000
Depreciation 150,000
Repairs and maintenance 10,000
240,000 55,000
= = 24
y= a + bx
cost fn = 55,000 + 24x

Weaknesses of Inspection of Accounts Method

The analysis of cost in to variable and non- variable element is very subjective. The latest cost details that are
available from the account will normally be used. What happens today may not be4 repeated in the future/
this may not be typical of either past or future cost behavior? Cost estimated based on this methods involves
individual and often arbitrary judgment and they may therefore lack the preceptor necessary when they are to
be used in making decision that involve large sums of money and that are sensitive to measurement errors.
The general cost fn is given by y= a + bx & from the scatter diagram, the value of a is 240.

Class Exercise
The following data was extracted from records of an assembling department in a particular period.
Cost Fixed Variables
D. Materials - 4,000,000
D. Labour - 3,500,000
Rent 1,000,000
Salaries 1,500,000
Electricity 200,000 300,000
2,700,000 7,800,000
Suppose the activity level for the period in question was x=20,000 units and assume fixed costs will remain
so:

Determine (a) the cost function

(b) The predicted cost for next year if x is expected to be 22,000 units.

Solution: (a) a=2700000

b= 7800000 390/=
20 000
Therefore the predictive cost function is C = 2,700,000 + 390q

(b) When q= 22000 units, C = 2700000 + 390 (22000)

= 11,280,000

The following illustration will be used to demonstrate how the other three methods are used:

Illustration
ABC Corporation wishes to set flexible budget for each of its operating department. A separate maintenance
departments performs all routine and major repair work on the corporation equipment and facilities. It has
been determined that costs is primarily ‘a function of the machine hours worked in various production
departments. The actual machine hours worked and maintenance costs incurred during the first four month
of 2004 are as follows:
 Period Machine hours Maintenance cost
January 800 350
February 1200 350
March 400 150
April 1600 550

Required:
a. Draw a scatter diagram
b. Compute variable maintenance cost/ machine hours and fixed maintenance cost per month using with
the high- low method.
c. Compute variable maintenance cost per month using with least square regression method

Methods 3: Scatter graph technique

Under this method, the coordinates of the cost and the associated level of activity in respect of historical records for a defined
period of time are plotted on a graph. A line of best fit is then drawn usually across the coordinates crossing the cost axis. This
technique fits a trend line to a series of historical data points and then projects the line into the figure for medium to long-term
forecasts.

Solution to illustration 1 (a)

C
O

S
T

Machine Hours
Methods 4: High- low method
Under this method, a previous data relating to a defined period of time is extracted from the historical records and in
particular, two previous data corresponding to the highest level of activity during the same period and the lowest level of
activity during the same period, together with their associated corresponding costs form the basis for the derivation of the
cost function. The differences between the total cost of the high output and the total cost of the low output will be the
variable cost of the different output levels.

The non-variables cost can be estimated at any level of activity by subtracting the variable cost from the total
cost. The variable element is given by
b=

Solution to illustration 1 (b)

Activity level Machine hour cost
Highest 1600 550
Lowest 400 150
1200 400
Variable costs = = = 0.33
Fixed cost: total cost= F.C + 0.33 x 1600→FC = 550- (0.33 X1600)
Cost Function = $17
Machine Hours = $ 17 + 0.33 machine hours.

Advantage of high- low method

Easy to use especially when a rough forecast is needed.

Disadvantages
 It doesn’t consider all the observations. Actually it ignores all the observations except two of them.
 It can’t measures the size of probable error
 Only one independent variable is considered
 The method assumes that relationship exists between the independent variables and dependent
variables and that this relationship is linear.

Practice Question with solution (students are advised to attempt the question without checking the answer and then compare their solution with
the solution given below).

The costs of operating the maintenance department of AB.C. Manufacturing Limited for the last four months have been given
as follows:

Month Total cost Production volume

KSh (Standard hours)
1 111,000 7,000
2 115,000 8,000
3 113,000 7,700
4 97,000 6,000

You are required to compute total cost for month five (5) when output is expected to be 7,500 standard hours.
Solution
Steps (a) Identify the highest activity and its corresponding total cost.
(b) Identify the lowest activity and its corresponding total cost
(c) Determine the difference in activities and the total costs
(d) The change in total cost due to the corresponding change in activities would be the variable cost per
standard hour
(e) Make necessary substitutions in either the high or low volume cost.
Standard Total
Hours Cost
Ffigh output 8,000 115,000
Low output 6,000 97,000
2,000 18,000
Variable cost per standard hour is

18.000
2000 = KSh 9 per standard hour

Substituting in either the high or low volume cost:

High Low
KSh KSh KSh
Total cost 115,000 97,000
Variable cost (800 x 9) 72,000 (6,000 x 9) 4.000
Fixed cost 43,000 43,000

The estimated cost of 7,500 standard hours of output would be:

Fixed cost 43,000

Total variable cost (7,500 x KSh 9) 67,500
Total cost 110,500

Method 5: Least Squares Method

This method determines mathematically the repression line of best fit. It is based on the principals that the
sum of the square of the vertical deviation from the line that is established using the method is less than the
sum of square of the vertical deviation from any other live that might be drawn. The regression equation for a
straight line (y=a + bx) that meets this requirement can be found from the following normal equation by
solving for a and b.

Normal equations:
∑y = n a + b∑x
∑xy = a∑x +b∑x2

Where n= Number of Observations

y= dependent variables
x = independent variable
a = fixed elements
b = variables element per units.

Solution to illustration 1 (c): Least Square Method

Observations x y x2 xy
1 January 800 350 6,400,000 280,000
2 February 1200 350 1,440,000 420,000
3 March 400 150 160,000 60,000
4 April 1600 550 2,560,000 880,000
∑x=4000 ∑y=1400 ∑x2=4,890,000 ∑xy=1,640,000
1400 = 4a + 4000b x 1000
1640000 = 4000 a + 4890000 b
1,400,000 = 4000 a + 4,000,000 b
1,640,000 = 4000 a + 4,890,000 b
-240,000 = - 890,000 b

Therefore, b = = 0.274

Illustration 2
The management account of Chania ltd provides the cost and activity data taken from past records as follows:
Cost (y) activity (units) .x
56 4
62 5
80 7
72 7
88 9
94 10

Required:
a) Calculate the fixed and variable element of cost using the least square methods
b) Forecast the total cost when the activity is 12 units

Solution
y x xy x2
56 4 224 16
62 5 310 25
80 7 560 49
72 7 504 49
88 9 792 81
94 10 940 100
€y = 452 €x= 42 €xy = 3330 €x2= 320

Substitute
(452 = 6a + 42b)
3330 = 42 a + 320 b
3164 = 42a + 294b
3330 = 42a + 320b
166 = 166b
b= 6.385
a = 30.6
thus y= 30.6 + 6.385

for 12 units cost = 30.6 + 6.585 (12)

PRACTICE QUESTION ONE
The management account of Chania ltd provides the cost and activity data taken from past records as follows:
Cost Activity (units)
56 4
62 5
80 7
72 7
88 9
94 10
Calculate the fixed and variable element of cost using the least square methods. Forecast the total cost of the
activity in 13units

QUESTION TWO
The following data has been provided by a catering company that prepares banquets and parties for both
individuals and business functions through the year. The data indicates that overhead expenses vary with the
direct labour hours expended.

Month Labour hours Overhead costs(sh.)

January 2,500 55,000
February 2,700 59,000
March 3,000 60,000
April 4,200 64,000
May 4,500 67,000
June 5,500 71,000
July 6,500 74,000
August 7,500 77,000
September 7,000 75,000
October 4,500 68,000
November 3,100 62,000
December 6,500 73,000
Total 57,500 805,000
Required
(a) Using regression analysis, calculate the variable cost per person for a cocktail party, if the following
additional information is given. The cost structure on a person basis is;

Food and beverages sh.15.00

Labour (0.5) 5.00 (15 marks)
(b) The company has asked you to prepare a bid for a 200 person cocktail party to be given next month.
Determine the minimum bid price the company would be willing to submit to earn a profit. (5 marks)

c) The following costs and activity data were taken from factory records.
Cost incurred Activity (units)
Sh Sh
656 80
692 86
683 87
698 94
707 95
703 97
712 104
i) Draw a scatter graph to represent the above information
ii) Determine a cost function using high low method
iii) Determine the regression equation using the least square method and interpret the regression equation
obtained (4 marks)
iv) Calculate the cost incurred when the activity level is 250 units (3 marks)